Sector Spotlight—More Semiconductor M&A on the Horizon?

A new round of consolidation could be about to work its way through the semiconductor industry. There were various reports circulating last week about some potential large deals percolating across the space. In an overall industry that is only getting more competitive, chipmakers know that if they get bigger via acquisitions they can quickly benefit from economies of scale, cutting duplicative costs while bulking up on the top line. A fresh M&A wave would be all about scale and cost synergies.

The first part of the latest M&A trend in semiconductors took place earlier this year, with communications chipmaker Broadcom (BRCM) agreeing to be bought by Avago Technologies (AVGO) for $37 billion and Altera (ALTR), a provider of programmable logic devices, getting taken out by Intel (INTC) in a $16.7-billion transaction.

Last week, Bloomberg reported that NAND flash chipmaker SanDisk (SNDK) had hired bankers to explore a possible sale. Shares of SanDisk last week rallied more than 12% on the news (though they’re still down 34% from the 52-week high), which named Micron Technology (MU) and Western Digital (WDC) as potential acquirers of the company. Both would have a legitimate interest in buying SanDisk: Micron would benefit from building up scale in its NAND business (the combined MU/SNDK market share in NAND would be equal to that of Samsung), while Western Digital would gain more exposure to NAND, a strategic way to hedge against flash making competitive inroads against its core hard disk drive business.

Bloomberg last week also reported that analog chipmakers Maxim Integrated Circuits (MXIM) and Analog Devices (ADI) are in talks about a possible merger. Gaining scale across the analog space would be the key objective of a deal between these two companies. Analog Devices has a lot of industrial exposure, while Maxim is more consumer focused. This would be a rather large transaction if it were to occur, as Analog Devices has a market cap of $18.8 billion and Maxim’s market cap stands at $11.3 billion.

There are a couple of smaller chipmakers with promising growth prospects (driven by new product cycles) that represent viable potential buyout targets. One is Monolithic Power Systems (MPWR), a provider of power management solutions for the industrial, communications, cloud computing, automotive and consumer markets. The company operates in attractive segments that offer high margins, while its products tend to be “sticky,” meaning customers are usually locked in for the long haul. Recently trading around $57 a share, Monolithic Power has a market cap of $2.2 billion.

The company generates about 44% of its revenue from its consumer unit—making chips for home appliances, battery management, LED lighting and gaming. The consumer piece of the business has been gaining upside momentum, with revenue in the second quarter rising 24% year over year. The communications unit (primarily chips used for telecom infrastructure), accounting for about 21% of total revenue, had a flat year over year performance in the latest quarter, while the industrial business (chips for autos, smart meters, security and power sources) provided 20% of revenue and advanced 34%. Revenue from the storage & computing unit (15% of revenue) rose 16%, with growth driven mainly by sales into the cloud and high-end PC segments.

After several years of R&D efforts, Monolithic Power recently announced that it would begin making solutions for advanced motion control, expanding its addressable market by as much as $3 billion. Motion control solutions are needed in anything requiring precise movement. Use cases include drones, robots and automobiles. Within the auto segment, there are plenty of niches where motion control chips could replace mechanical parts, resulting in big savings for automakers. Monolithic Power management believes motion control could quickly ramp to represent 10% of total revenue.

For 2015, the consensus revenue estimate of $331.2 million represents growth of just over 17%. The stock trades at 31 times the 2015 consensus EPS estimate of $1.84. On the 2016 consensus of $2.23, the forward P/E of 25 is 1.2 times the expected growth rate of 21%. Monolithic Power shares last week hit an all-time high of $57.67; so far this year, the stock has advanced 14%.

Cavium (CAVM), a provider of networking and communications chips, is another potential acquisition target. In terms of end markets, the enterprise/datacenter segment makes up half of the company’s total revenue, while service providers represent 40% and broadband accounts for 10%. Thanks to its strong technology lead, the chipmaker is experiencing solid demand across its entire product portfolio, as hefty increases in global mobile data traffic and cloud datacenter IP traffic sharply boost the requirements for network scalability, programmability, performance and manageability.

Cavium’s new design wins so far this year are running 30% higher than at the same time last year. Design wins eventually turn into revenue once production begins. In the second quarter, Cavium’s revenue advanced 16%. For 2015, the consensus revenue estimate of $420 million represents growth of 12.6%. Revenue growth for next year is expected to accelerate thanks to solution upgrades and new product cycles. The 2016 consensus revenue estimate of $512.6 million indicates growth of 22%.

This past summer, Cavium expanded its core Octeon networking chip portfolio by adding low-power processors that meet the special requirements of compact networking/security appliances, storage appliances, wireless infrastructure, switches and routers. The new LiquidIO 2 application acceleration solution is a high-end programmable network adapter that addresses larger datacenter use cases. Four tier-1 switch vendors are now designing Ethernet switches around Cavium’s new Xpliant switch silicon. The main attractive feature: Support for new protocols can be added via software, meaning Xpliant eliminates the need for older switches to be totally re-engineered, a much more costly process.

Cavium’s new Thunder ARM-based datacenter and cloud processor is expected to be the company’s largest 2016 incremental revenue generator. An extension of Octeon, Thunder expands Cavium’s presence in the $12-billion datacenter silicon market. More than 30 customers are actively engaged in Thunder trials; the response so far has been quite positive, with many evaluations already resulting in design wins. Thunder specifically addresses the roughly $2.5-billion data-plane segment of the datacenter market, which covers packet processing for traffic going into and out of the cloud.

At a recent price of $70 a share, Cavium has a market cap of $3.9 billion. The stock trades at 44 time the 2015 consensus EPS estimate of $1.58. On the 2016 consensus of $2.08 a share, the forward P/E of 33.6 is 1.06 times the expected growth rate of 31.6%. Cavium shares so far this year are up 13%.

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